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 The Labor Market in the
Macroeconomy 29
CHAPTER
OUTLINE
The Labor Market: Basic Concepts
The Classical View of the Labor Market
The Classical Labor Market and the Aggregate Supply Curve
The Unemployment Rate and the Classical View
Explaining the Existence of Unemployment
Sticky Wages
Efficiency Wage Theory
Imperfect Information
Minimum Wage Laws
An Open Question
The Short-Run Relationship between the
Unemployment Rate and Inflation
The Phillips Curve: A Historical Perspective
Aggregate Supply and Aggregate Demand Analysis and the
Phillips Curve
Expectations and the Phillips Curve
Inflation and Aggregate Demand
The Long-Run Aggregate Supply Curve, Potential
Output, and the Natural Rate of Unemployment
The Nonaccelerating Inflation Rate of Unemployment
(NAIRU)
Looking Ahead
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 The Labor Market: Basic Concepts

The labor force (LF) is the number of employed plus unemployed:

LF = E + U

unemployment rate The number of people unemployed as a percentage of

the labor force.

U
unemployment rate 
LF

When a person stops looking for work, he or she is considered out of the labor
force and is no longer counted as unemployed.

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 frictional unemployment The portion of unemployment that is due to the
normal working of the labor market; used to denote short-run job/skill matching
problems.

structural unemployment The portion of unemployment that is due to

changes in the structure of the economy that result in a significant loss of jobs
in certain industries.

cyclical unemployment The increase in unemployment that occurs during

recessions and depressions.

A decline in the demand for labor does not necessarily mean that
unemployment will rise. The resulting excess supply of labor will cause the
wage rate to fall, until a new equilibrium is reached, and everyone who wants a
job at the lower wage rate will have one.

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 The Classical View of the Labor Market

Classical economists assumed that the wage rate adjusts to equate the
quantity demanded with the quantity supplied, thereby implying that
unemployment does not exist.

labor demand curve A graph that illustrates the amount of labor that firms
want to employ at each given wage rate.

labor supply curve A graph that illustrates the amount of labor that
households want to supply at each given wage rate.

At equilibrium, the people who are not working have chosen not to work at that
market wage. There is always full employment in this sense.

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  FIGURE 29.1 The Classical Labor Market

Classical economists believe that the labor market always clears.

If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1.
Anyone who wants a job at W1 will have one.
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 The Classical Labor Market and the Aggregate Supply Curve

The classical idea that wages adjust to clear the labor market is consistent with
the view that wages respond quickly to price changes.

In the absence of sticky wages, the AS curve will be vertical.

In this case, monetary and fiscal policy will have no effect on real output.

Indeed, in this view, there is no unemployment problem to be solved!

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 The Unemployment Rate and the Classical View

Some economists argue that the unemployment rate is not a good measure of
whether the labor market is working well. The economy is dynamic and at any
given time some industries are expanding and some are contracting.

A positive unemployment rate as measured by the government does not

necessarily indicate that the labor market is working poorly. The measured
unemployment rate may sometimes seem high even though the labor market is
working well.

Economists who view unemployment this way do not see it as a major problem.
There are other views of unemployment, as we will now see.

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 Explaining the Existence of Unemployment

Sticky Wages

sticky wages The downward rigidity of wages as an explanation for the

existence of unemployment.

 FIGURE 29.2 Sticky Wages

If wages “stick” at W0
instead of falling to the new
equilibrium wage of W*
following a shift of demand
from D0 to D1, the result will
be unemployment equal to
L0 − L1.

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 Social, or Implicit, Contracts

social, or implicit, contracts Unspoken agreements between workers and

firms that firms will not cut wages.

relative-wage explanation of unemployment An explanation for sticky

wages (and therefore unemployment): If workers are concerned about their
wages relative to other workers in other firms and industries, they may be
unwilling to accept a wage cut unless they know that all other workers are
receiving similar cuts.

Explicit Contracts

explicit contracts Employment contracts that stipulate workers’ wages,

usually for a period of 1 to 3 years.

cost-of-living adjustments (COLAs) Contract provisions that tie wages to

changes in the cost of living. The greater the inflation rate, the more wages are
raised.

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 Efficiency Wage Theory

efficiency wage theory An explanation for unemployment that holds that the
productivity of workers increases with the wage rate. If this is so, firms may
have an incentive to pay wages above the market-clearing rate.

Empirical studies of labor markets have identified several potential benefits that
firms receive from paying workers more than the market-clearing wage. Among
them are lower turnover, improved morale, and reduced “shirking” of work.

Even though the efficiency wage theory predicts some unemployment, the
behavior it is describing is unlikely to account for much of the observed large
cyclical fluctuations in unemployment over time.

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 ECONOMICS IN PRACTICE

Congress Extends Unemployment Insurance

The standard unemployment benefits are managed by states and typically last
for 26 weeks. In the recent recession the federal government has provided
extended benefits to the unemployed, offering as much as an additional 47
weeks.
Part of the debate surrounding the so-called fiscal cliff in Congress involved
whether these benefits should be continued.
In 2012 the average duration of unemployment was 39.4 weeks. Following the
1980–1982 recession, the average duration peaked at 20.0 weeks in 1983, and
following the 1990–1991 recession, it peaked at 18.8 weeks in 1994.

THINKING PRACTICALLY
1.Can you think of any reasons that long-term unemployment is higher in this recession
than it has been in the past?
2.Some policy makers worry that extending unemployment benefits will actually increase
unemployment. Can you think of any reason this might be true?

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 Imperfect Information

Firms may not have enough information at their disposal to know what the
market-clearing wage is.

In this case, firms are said to have imperfect information.

If firms have imperfect or incomplete information, they may simply set wages
wrong—wages that do not clear the labor market.

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 ECONOMICS IN PRACTICE

The Longer You are Unemployed, the Harder it is to Get a Job

The authors of a recent paper conducted an interesting experiment to try to

figure out what long-term unemployment does to one's eventual job prospects.
They sent out fictitious job resumes to real job postings in 100 U.S. cities. Over
12,000 resumes were sent in response to 3,000 job postings. Fictitious job
applicants were randomly assigned unemployment durations of 1 to 36 months.
The researchers then tracked “call backs” to these resumes.
The result? Call backs decreased dramatically as a response to unemployment
duration. This effect was especially strong in cities that had strong job markets.
The researchers suggested that employers were likely inferring low worker
quality based on long duration of unemployment.

THINKING PRACTICALLY
1.What does this result tell us about how easy it is for firms to see worker quality?

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 Minimum Wage Laws

minimum wage laws Laws that set a floor for wage rates—that is, a minimum
hourly rate for any kind of labor.

In 2013, the federal minimum wage was $7.25 per hour. If some teenagers can
produce only $6.90 worth of output per hour, no firm would be willing to hire
them.

An Open Question

The aggregate labor market is very complicated, and there are no simple
answers to why there is unemployment. Which argument or arguments will win
out in the end is an open question.

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 The Short-Run Relationship between the Unemployment Rate
and Inflation
The unemployment rate (U) and aggregate output (income) (Y) are negatively
related: when Y rises, the unemployment rate falls, and when Y falls, the
unemployment rate rises.
The relationship between aggregate output and the overall price level is
positive: When P increases, Y increases, and when P decreases, Y decreases.

 FIGURE 29.3 The Aggregate

Supply Curve
The AS curve shows a positive
relationship between the price
level (P) and aggregate output
(income) (Y).

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 The Short-Run Relationship between the Unemployment Rate
and Inflation

 FIGURE 29.4 The Relationship

between the Price Level and the
Unemployment Rate

This curve shows a negative

relationship between the price
level (P) and the unemployment
rate (U).
As the unemployment rate
declines in response to the
economy’s moving closer and
closer to capacity output, the price
level rises more and more.

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 inflation rate The percentage change in the price level.

Phillips Curve A curve showing the relationship between the inflation rate
and the unemployment rate.

 FIGURE 29.5 The Phillips

Curve

The Phillips Curve shows

the relationship between
the inflation rate and the
unemployment rate.

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 The Phillips Curve: A Historical Perspective

 FIGURE 29.6 Unemployment

and Inflation, 1960–1969

During the 1960s, there

seemed to be an obvious
trade-off between inflation
and unemployment.
Policy debates during the
period revolved around this
apparent trade-off.

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 The Phillips Curve broke down in the 1970s and 1980s.

 FIGURE 29.7
Unemployment and
Inflation, 1970–2009
From the 1970s on, it
became clear that the
relationship between
unemployment and
inflation was anything
but simple.

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 Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

 FIGURE 29.8 Changes in the Price Level and Aggregate Output Depend on Shifts in
Both Aggregate Demand and Aggregate Supply

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 The Role of Import Prices

 FIGURE 29.9 The Price of Imports, 1960 I–2012 VI

The price of imports changed very little in the 1960s and early 1970s.
It increased substantially in 1974 and again in 1979-1980.
Between 1981 and 2002, the price of imports changed very little.
It generally rose between 2003 and 2008, fell somewhat in late 2008 and early 2009, rose
slightly to 2011 and then remained flat.

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 Expectations and the Phillips Curve

If inflationary expectations increase, the result will be an increase in the rate of

inflation even though the unemployment rate may not have changed. In this
case, the Phillips Curve will shift to the right.

If inflationary expectations decrease, the Phillips Curve will shift to the left—
there will be less inflation at any given level of the unemployment rate.

Inflation and Aggregate Demand

Inflation is affected by more than just aggregate demand. Where inflation

depends on both the unemployment rate and cost variables, there will be no
stable Phillips Curve unless the cost variables are not changing.

Therefore, the unemployment rate can have an important effect on inflation even
though this will not be evident from a plot of inflation against the unemployment
rate—that is, from the Phillips Curve.

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 The Long-Run Aggregate Supply Curve, Potential Output, and
the Natural Rate of Unemployment

 FIGURE 29.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment
If the AS curve is vertical in the long run, so is the Phillips Curve.
In the long run, the Phillips Curve corresponds to the natural rate of unemployment
—that is, the unemployment rate that is consistent with the notion of a fixed long-run
output at potential output.
U* is the natural rate of unemployment.
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 natural rate of unemployment The unemployment that occurs as a normal
part of the functioning of the economy. Sometimes taken as the sum of
frictional unemployment and structural unemployment.

The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

NAIRU The nonaccelerating inflation rate of unemployment.

 FIGURE 29.11 The NAIRU Diagram

To the left of the NAIRU, the
price level is accelerating
(positive changes in the inflation
rate);
To the right of the NAIRU, the
price level is decelerating
(negative changes in the
inflation rate).
Only when the unemployment
rate is equal to the NAIRU is the
price level changing at a
constant rate (no change in the
inflation rate).
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 Looking Ahead

This chapter concludes our basic analysis of how the macroeconomy works.

In the preceding seven chapters, we have examined how households and firms
behave in the three market arenas—the goods market, the money market, and
the labor market.

We have seen how aggregate output (income), the interest rate, and the price
level are determined in the economy, and we have examined the relationship
between two of the most important macroeconomic variables, the inflation rate
and the unemployment rate.

In the next chapter, we use everything we have learned up to this point to

examine a number of important policy issues.

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 REVIEW TERMS AND CONCEPTS

cost-of-living adjustments (COLAs) NAIRU

cyclical unemployment natural rate of unemployment

efficiency wage theory Phillips Curve

explicit contracts relative-wage explanation of unemployment

frictional unemployment social, or implicit, contracts

inflation rate sticky wages

labor demand curve structural unemployment

labor supply curve unemployment rate

minimum wage laws

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